AI for Trading Series №8: Exchange Traded Funds (ETFs)

Learn about ETFs and how they are used by investors.

Photo by William Iven on Unsplash

In this article, we will learn about the Exchange Traded Funds (ETFs) and how they work. To understand more about ETFs, let us first understand few drawbacks of open-ended and close-ended mutual funds. You can read more about what are open-ended and close-ended mutual funds in my post here.

Drawbacks of Mutual Funds

Drawbacks of Open-ended Mutual Funds

1. An open-ended mutual funds may need to maintain parts of their assets under management (AUM) in cash to let investors withdraw their shares on any given day. This dilutes the fund’s overall performance.
2. Open-ended mutual fund limits the number of times you can invest/withdraw within a time frame.
3. Fund share price is determined when the market closes.

Drawbacks of Close-ended Mutual Funds

Close-ended mutual funds tried to overcome the above problems by making their shares tradable in stock market. But market-value of these shares may diverge from the fund’s portfolio.

Based on the drawbacks mentioned above, we basically need a fund that does not need to hold a reserve of cash and whose market value matches its portfolio. This can be achieved by leveraging ETFs.

Exchange Traded Funds (ETFs)

ETFs, like mutual funds, allows us to invest in portfolio of stocks. They are tradable on stock-exchange like stocks. Market price of ETF closely follows the value of underlying portfolio. There are some common ways in which investors use ETFs which include:

• ETFs make it easier to invest in commodities (oil and natural gas, gold and silver, corn and cows) and international stocks.
• ETFs are also used for hedging.

Commodity Futures

For investors, it is easier for them to buy Futures contract that are tied to commodities. Futures contract are standardised agreements between two parties to trade an asset at a future date, at a predetermined price. If you trade futures directly, then you’ll need to close the position or roll it over by the time the contract is due.

How to close a futures position?

Assuming you enter into a futures contract with a farmer to buy one metric tone of cocoa at a fixed price and fixed date, six months from now. The participant who agrees to buy is “long” the future. The participant who agrees to sell is “short” the future.

Entering a Futures Contract. (Source: AI for Trading nano degree course on Udacity)

After 6 months, you are required to pay cash to the farmer and the farmer is required to send you one tonne of cocoa.

Futures Contract Complete. (Source: AI for Trading nano degree course on Udacity)

If you entered into a futures contract and wish to cancel, or “close” your long position, you may do so by entering into an opposing position in the same asset, at the same due date, i.e., you must enter into a short position to sell one metric ton of cocoa at a fixed price and on the same due date.

Closing the Futures Position — I. (Source: AI for Trading nano degree course on Udacity)

Finally, the situation becomes in such a way that you paid for a ton of cocoa and then immediately sold that cocoa to someone else to get your money back.

Closing the Futures Position — II

A forward contract is a specific agreement between two parties that isn’t standardised for other buyers or sellers. Since forward contracts are tailored specifically by the two counter-parties, they’re not tradable like futures contracts. Forward contracts are also referred to as “bespoke”, which is just another word for “custom made” or “tailor made”.

Commodity ETFs

• Investors who wish to gain exposure to commodities may buy futures contracts, but this requires them to roll over their positions regularly.
• Rolling over a futures contracts involves closing out the existing position before its due date and then taking a new position that is due at a later date.
• Commodity ETFs handle this, so investors could more easily buy and hold shares in a commodity ETF and not worry about rolling over individual futures contracts.

International ETFs

• If investors wish to trade international stocks, these stocks would be listed on a stock exchange of another country, and may be in a different time zone.
• This means that trading is done during the stock exchange’s open hours, which may not be as convenient for the investor.
• International ETFs are traded on a local stock exchange, while they are still linked to the stocks that are listed abroad

Hedging with ETFs

Consider a scenario where you have a portfolio that holds many stocks in the S&P500. You can take some short positions in an ETF that tracks the S&P500. The most ETF popular is the SPDR S&P500 ETF. When the overall market goes down, your portfolio goes down with it. However, you short positions in the SPDR ETF gain at the same time, thus limiting the impact of market downturn. The reverse situation happens when the market goes up.

Hedge funds use ETFs for hedging purposes. They may construct a portfolio that optimizes their exposure to certain stocks that they believe will perform well, and in order to cancel out general market movements, they may also short an ETF that contains a similar set of stocks. They may also short sector-specific ETFs if they wish to have a neutral exposure to those sectors.

ETF Sponsors

ETF Sponsors are the financial institutions that issue ETFs. We can think of them as most similar to the fund managers of mutual funds, because they design a portfolio and issue ETF shares. ETF Sponsors may generally charge lower fees compared to other types of funds, in part because of some efficiencies that make it cheaper to run the fund. The largest ETF sponsor is the BlackRock’s iShares.

So far ETFs sound pretty much like mutual funds. Recall that investors give their cash to mutual fund and then the mutual fund, then invests that cash in a portfolio of stocks. With ETFs, the ETF sponsor only makes transactions with special partners called Authorized Participants (APs). Major APs include Goldman Sachs, Morgan Stanley and Fortis Bank.

Authorized Participants (APs)

Authorized Participants (APs) and ETF Sponsors partner together to make the ETF system work. We can think of APs as the intermediaries between investors and the ETF Sponsor. Unlike mutual funds or hedge funds, ETF Sponsors don’t take cash to invest, nor do they deal directly with investors. ETF Sponsors take a portfolio of stocks instead of cash, and they trade with APs instead of with investors. ETF Sponsors and APs create ETF shares with the “create process”.

Create Process

The “create process” involves the following steps:

1. The Authorized Participant buys stocks and bundles them in the same proportions as defined by the ETF Sponsor.
2. The AP makes a trade with the ETF Sponsor.
3. The ETF Sponsor creates ETF shares and gives these to the AP, in exchange for a bundle of stocks.
4. The APs go to the stock market and sell their ETF shares on the open market. The investors can buy these shares and now have investments linked to all of the stocks that are in the ETF portfolio.

You’ll notice that an ETF sponsor issues shares similar to what a mutual fund does. The main difference here is that the sponsor only deals with a set of APs that are financial institutions. Also, unlike a mutual fund, the ETF sponsor does not receive cash in exchange for its shares. Instead, they receive a bundle of stocks that matched the portfolio designed by the sponsor.

Redeem Process

When individual investors wish to divest their holdings in an ETF, they can sell their shares to other investors on the stock exchange, like they would with a stock. In this process, they don’t need to interact with the ETF sponsor. An AP can decide to redeem ETF shares for the original portfolio of stocks. This is essentially reversing the original ETF share creation process and is called redeem process and is a transaction between ETF Sponsor and APs. The redeem process takes ETF shares out of circulation, and puts the underlying stocks back into the market.

The redeem process involves the following steps:

1. The AP buys ETF shares from investors in the stock market.
2. The AP trades these ETF shares with the ETF Sponsor in exchange for the original stocks.
3. The AP sells these stocks on the stock exchange.

Now, during this entire process, there are ways in which the APs make money, such as Arbitrage.

Arbitrage

Arbitrage is the act of simultaneously buying and selling assets that are interchangeable, in order to profit from pricing differences. Arbitrage plays a role in making markets more efficient, which means that prices are more consistent for the same asset. When investors and funds collectively find and act on arbitrage opportunities, they reduce price discrepancies in the market.

Let’s understand Arbitrage in a bit easy way. Let’s say farmer A sells apples for $1 each and farmer B sells a bag of 10 apples for $9. Now, in this case I could buy 10 individual apples from farmer A or I could buy 10 apples for $9 from farmer B and there are a ton of customers who want to buy an apple for a dollar. This is an opportunity for an Arbitrage.

In this scenario, you would tend to buy low and sell high. In this case, you would buy 10 apples for $9 and then sell them for $1 each. I would also not want to be stuck holding a bag. In this case, I would try to find 10 customers who want to purchase an apple, and at the same time, I would get into an agreement with farmer B, to buy the bag. Hence, I am buying and selling at the same time and earned a dollar profit by using arbitrage.

Misaligned ETF prices and Arbitrage Opportunity

The market value of an ETF share may diverge from the market value of its underlying portfolio of stocks (its NAV). If an ETF share price is higher than its NAV, we say it’s trading at a premium. If an ETF share price is lower than it’s NAV, we say it’s trading at a discount. The difference between the ETF share price and its NAV can be called its basis.

Now, an AP would see the difference as an arbitrage opportunity. So, the AP triggers the create process. Then, the AP would give the bundle of stocks to the ETF sponsor, which issues more ETF shares for the AP. Then the AP sells the ETF shares to the investors on the stock exchange. The create process injects more ETF shares into the market place. The large purchases of a company’s stocks push up their stock prices. Moreover, the additional supply of ETF shares helps to bring down the price of the ETF.

The AP, profits from the difference between the buy price of the stock and the sell price of the ETF shares. As long as there is a price discrepancy that is large enough for arbitrage opportunities, the APs will buy low and sell high until the prices are aligned.

This article is a part of my ‘AI for Trading’ Series. You can find the link to previous articles from the series: https://thestockgram.com/blog

References

1. AI for Trading nano degree course on Udacity.
2. AI for Trading: GitHub